The financial crisis, in addition to forcing regulators worldwide to address the perceived deficiencies of the market, has also prompted fund industry associations in Europe and the U.S. to reconsider the nature, attendant risks and investor perception of their various products.
With respect to money market funds (‘MMF’) the lack of an agreed pan-European definition and the industry’s efforts to address the consequential investor misunderstanding of the product has resulted in a report by the European Fund and Asset Management Association (‘EFAMA’) and the Institutional Money Market Funds Association (‘IMMFA) which contains precise rules to clarify the MMF label.
The stability of MMFs, which have traditionally been viewed as offering safety of principal, liquidity and competitive sector-related returns, came into question after a number of European ‘enhanced’ MMFs experienced difficulties at the onset of the current financial crisis. Investor concerns were compounded in September 2008 when a U.S. MMF, the Reserve Primary Fund, a successor to The Reserve Fund, billed as ‘America’s first money market fund’, ‘broke the buck’ due to its overexposure to unsecured Lehman debt securities. This event caused a run on MMFs on both sides of the Atlantic.
Currently, there is no common definition of MMFs across the EU. While the UCITS Directive establishes minimum standards for investment funds, it leaves the definition of fund categories to national supervisors. Consequently, some categories of MMF are very narrowly defined in terms of minimum credit quality and maximum duration while others permit broader exposure limits. As a result, during the crisis, MMFs were differently affected by the extraordinary contraction in liquidity with those which had taken extended credit and duration risk being most at risk.
To restore confidence in the product and clarify for investors the distinction between conservative MMF and those which seek enhanced yields, IMMFA and EFAMA have proposed for the European sector a ‘robust’ single category of MMF composed of two types: ‘short term’ and ‘regular’ defined so as to limit the main risks to which MMFs are exposed i.e. interest rate, credit/credit spread and liquidity. Under the proposals, any existing funds which fall outside the two categories will be permitted to keep the money market label for a transitional period of three years but during this period will be grouped under the ‘other’ money market fund category. By 30th June 2012 any funds which remain outside the proposed definition will lose their MMF status.
MMFs originated in the United States in the early 1970s and the SEC subsequently, in 1983, established specific regulations, known as Rule 2a-7, defining and setting standards for the product with respect to maturity, quality and diversification. The basic objective of these rules is to limit a fund’s exposure to credit risk and interest rate risk. In light of the market disruptions of September 2008, however, the U.S. regulators and industry representatives have been actively discussing appropriate steps to bolster the stability of MMFs. Most notably, the Investment Company Institute issued its comprehensive Report of the Money Market Working Group, while the US Treasury Department issued a White Paper on Financial Regulatory Reform which embodies the Obama Administration’s ambitious proposals to reform the entire financial services industry, and contains a specific set of recommendations for the future regulation of MMFs.
Most recently, on June 24th 2009, the SEC proposed changes to Rule 2a-7 that would require MMFs to hold a portion of their portfolios in highly liquid investments, reduce their exposure to long-term debt and restrict their investments to only the highest quality portfolio securities. The proposals would also require monthly reporting of portfolio holdings and allow suspension of redemptions if a fund ‘breaks the buck’ to allow for the orderly liquidation of fund assets. The proposals are open for comment for 60 days after their publication in the Federal Register and are likely to be refined as they proceed through the administrative process. If enacted in a form similar to those proposed, the new rules, would represent a major step by the SEC to enhance the stability of MMFs, particularly during periods of economic distress.
The proposals put forward by EFAMA and IMMFA follow recommendations made in the de Larosiere Report, which highlighted the need for a common definition of MMFs in Europe and a stricter codification of the assets in which they can invest. The boards of both industry associations have unanimously endorsed the proposals put forward in the report and are now seeking the support of fund managers, regulatory authorities and performance measurement agencies to ensure that the definition is used across Europe. As Ireland is a leading European domicile for MMFs with E313 billion in assets under management as of March 2009, the proposals are important and if adopted would secure the success of Ireland as a domicile of choice for MMFs in Europe.